Tuesday, November 25, 2014

We’ve written extensively about the evils of non-traded REITs. You can find our non-traded REIT blog posts here. As bad as non-traded REITs are – and they’re so bad no one should ever buy one – registered, non-traded Equipment Leasing Direct Participation Programs (DPPs) are worse.

Examples of equipment leasing DPPs include the series of LEAF and ICON trusts we discuss below. Equipment leasing DPPs provide a stark illustration of the DPP deceit which infects non-traded REITs, non-traded BDCs and oil & gas and managed futures DPPs. These investments can only be sold because of the motivation provided by high DPP sales commissions and the lack of price transparency and market discipline.

Direct Participation Programs are registered with the SEC and sold to retail investors but not listed on public exchanges. Without an active secondary market for the shares, there is no reliable way for retail investors to independently judge the prices charged by sponsors and brokerage firms. This lack of secondary trading in shares of DPPs also allows inefficient and self-serving management that would be disciplined by the market for corporate control to persist and harm DPP investors.

In an equipment leasing DPPs a sponsor sells limited partnership units, deducts substantial offering costs and invests the remainder in a pool of equipment leases leveraged up with additional borrowing. Like other DPPs, equipment leasing DPPs market a predictable income stream but a substantial portion of distributions to investors are a return of capital not of income. Equipment leasing partnerships promote the tax benefits investors can achieve through depreciation deductions and interest payments on borrowing used to leverage. The depreciation and interest deductions can only be used to offset income from other passive investments and so this “benefit” is trivial for most investors.

The purchased leases can either be operating leases or full-payout leases. In operating leases, the trust retains ownership of the equipment and counts on the residual value of the equipment to be great enough, when combined with the lease payments received over the term of the lease, to pay the cost of the equipment including borrowing costs and return a profit to investors. In financing or “full payout” leases the trust has no residual interest in the equipment but is instead just financing the operator’s purchase and use of the equipment. Investors in equipment leasing DPPs are effectively putting up capital and borrowing money to make loans backed by equipment to poor credit-quality borrowers.

As if that wasn’t bad enough, the sponsor and its affiliates deduct high up front and annual fees which guarantee that investors will lose money. Figure 1 is a table from the LEAF III prospectus available on the SEC website here.

Figure 1. Fee Table excerpt from LEAF III Prospectus

In this altogether typical equipment leasing DPP, upfront fees are 21.27% and reserves are 1% of investor’s capital. The Sponsor was to take $25,527,491 in fees from the $120,000,000 raised, set aside $1,200,000 in reserves and invest only $93,272,509 in leases. In a competitive market the investment returns on $93.3 million in leases cannot generate returns sufficient to compensate investors for risks borne on $120,000,000 of invested capital.

In addition to the cash investments in leases, LEAF III financed 80% of its lease portfolio with debt. The Sponsor received a 2% acquisition fee and 4% of gross rental revenue on operating leases and 2% of gross revenue on full payout leases each year. Thus, the Sponsor was paid for enlarging the lease portfolio quickly without regard for the financing costs or the quality of the leases bought, creating enormous conflicts of interest and ensured investors would lose money.

Completely predictably, LEAF III investors suffered significant losses. Figure 2 summarizes LEAF III results from 2007 to 2013. LEAF III investors’ losses are indicative of losses suffered by investors in equipment leasing DPPs more generally. The amortized offering costs, acquisition and management fees charged by the Sponsor can only be covered by lease revenues if there are no credit losses on leases extended to bad credit quality borrowers who face less penalty upon default than if they defaulted on bonds. That is, these equipment leasing programs might work if and only if the leases were backed by the full faith and credit of the US Treasury. Not surprisingly, credit losses have been substantial.

Figure 2. LEAF III’s Predictable Losses

Figures 3 and 4 present investors’ experience in the LEAF and ICON leasing programs. For each equipment leasing DPP we calculate the amount investors have made or lost. Investors in the LEAF series have lost $224.5 million and investors in the ICON series have lost $177.5 million as of December 31, 2013. Investors in bonds, stocks and even stocks of publicly traded equipment leasing companies earned substantial returns.

If an investor wanted equity exposure to equipment leases, he/she could buy common stock in equipment leasing companies. The losses investors suffer in equipment leasing DPPs are a result of high fees and shocking conflicts of interest – not problems in the equipment leasing or broader stock market. Figure 3 reports that had the same investments investors made in the LEAF funds been made instead in a market-capitalization weighted portfolio of publicly traded leasing companies, investors would have made $292 million. Thus, LEAF program investors lost $515 million by virtue of LEAF’s high costs and conflicts of interest. If the LEAF investors had invested the same amounts, at the same times, in the broad stock market they would have earned $186 million and would have earned $83 million in Treasury securities.

Figure 3. LEAF Equipment Leasing Programs1

Figure 4 reports that had the same investments investors made in the ICON funds been made instead in a market-capitalization weighted portfolio of publicly traded leasing companies, investors would have made $969 million. Thus, ICON program investors lost $1,146 million by virtue of ICON’s high costs and conflicts of interest. If the ICON investors had invested the same amounts, at the same times, in the broad stock market they would have earned $684 million and would have earned $363 million in Treasury securities.

Figure 4. ICON Equipment Leasing Programs

Thus despite being tied up in risky, illiquid investments for many years, investors in equipment leasing DPPs received substantially less than their original investments when investors in the equipment leasing industry, and in the broad stock and bond markets earned substantial returns.

1 Observant readers will note that the first two LEAF funds were called “Lease Equity Appreciation Fund I and II. It appears in the review process the SEC required LEAF to insert this language into the Lease Equity Appreciation Fund II registration statement. “Despite being named "Lease Equity Appreciation Fund II, L.P.," our equipment leases will not have any equity appreciation.” See http://www.sec.gov/Archives/edgar/data/1294154/000095011604003124/s-1a.txt. None of the Lease Equity Appreciation Fund I filings or previous versions of the registration statements for Lease Equity Appreciation Fund II contained this language undoing the blatantly misleading naming of the funds.

Thursday, November 13, 2014

We’ve shown in recent posts that UBS underwrote $1.7 billion of unmarketable ERS and $1.35 billion of COFINA bonds and bought them into the UBS PR Funds in 2007 and 2008. You can find our earlier blog posts available here. UBS made room for these ERS and COFINA bonds by selling out of the Funds, roughly $3 billion of other bonds UBS didn’t underwrite. UBS bought the ERS and COFINA bonds it underwrote in 2007 and 2008, because there was no other market for the bonds it was underwriting.

The disastrous losses suffered by investors in the UBS PR Funds in 2013 are directly traceable to UBS putting its interests ahead of its clients in 2008 as we show in three examples.

Fixed Income Fund II’s

Figure 1 categorizes the Fixed Income Fund II’s November 30, 2012 holdings into ERS, COFINA and Other. ERS bonds are 27.5% of the portfolio, COFINA bonds are 21.3% of the portfolio and Other Investments are 51.1% of the portfolio.
The ERS bonds lost 50.3% of their value from November 30, 2012 to December 13, 2013. The COFINA bonds lost 29.7% from November 30, 2012 to December 13, 2013. Other investments in the Fund lost between 4.8% and 15.8% of their value between November 30, 2012 and December 31, 2013.
If the ERS and COFINA bonds had only suffered the losses suffered on the rest of the Fixed Income Fund II’s portfolio, the Fund would have only lost $140.2 million instead of between $201 and $251 million.1

Figure 1. Fixed Income Fund II Asset and Losses Allocation

Fixed Income Fund III

The same pattern found in the Fixed Income Fund III can be observed in the other UBS PR funds. Figure 2 presents similar analysis for Fixed Income Fund III. ERS bonds are 28.1% of the portfolio, COFINA bonds are 15.1% of the portfolio and Other Investments are 56.8% of the portfolio.

The ERS bonds lost 45.4% from June 30, 2013 to December 13, 2013. The COFINA bonds lost 26.2% from June 30, 2013 to December 13, 2013. Other investments in the Fund lost between 2.6% and 12.5% of their value between June 30, 2013 and December 31, 2013.

If the ERS and COFINA bonds had only suffered the losses suffered on the rest of the Fund’s portfolio the Fund would have only lost $103.6 million instead of between $151 million and $197 million.

Figure 2. Fixed Income Fund III Asset and Losses Allocation

Fixed Income Fund IV

Figure 3 presents similar analysis for Fixed Income Fund IV. ERS bonds are 25.2% of the portfolio, COFINA bonds are 19.4% of the portfolio and Other Investments are 55.4% of the portfolio.

The ERS bonds lost 44.8% from March 31, 2013 to December 13, 2013. The COFINA bonds lost 27.7% from March 31, 2013 to December 13, 2013. Other investments in the Fund lost between 8.0% and 12.2% of their value between March 31, 2013 and December 31, 2013.

If the ERS and COFINA bonds had only suffered the losses suffered on the rest of the Fund’s portfolio the Fund would have only lost $107 million instead of $206 ($185) million.

Figure 3. Fixed Income Fund IV Asset and Losses Allocation

So now we see what hell hath UBS wrought with its self-dealing. We estimate these three funds lost between $537 million and $654 million. Of these losses, the UBS underwritten ERS and COFINA bonds lost $464 million. That is, between 71% and 86% of the billions of dollars the UBS PR Funds lost in 2013 was the direct result of the UBS underwritten ERS and COFINA bonds for which there was no market.

1 We estimated a range of possible losses on the Funds’ portfolios because the Funds do not produce financial statements for the periods over which we have spanning holdings data and the number of units of each fund changes significantly over time.

Yesterday we showed that UBS underwrote $1.7 billion of unmarketable ERS bonds and bought them into the UBS PR Funds in 2008, available here. Today, we show similar conflicts led UBS to underwrite unmarketable 2007 and 2008 Puerto Rico Sales Tax Financing Corporation (COFINA) bonds and stuff them into the Funds. COFINA issued two series of bonds in 2007 and one Series in 2008.

COFINA 2007 Series A

UBS Investment Bank was 1 of 19 co-underwriters of the $2.7 billion Series A bonds targeting mainland investors. See Figure 1.

We don’t know how much of the COFINA 2007 Series B bonds UBS committed to sell but we do know UBS purchased $614 million or 46% of the $1.330 billion COFINA 2007 Series B bonds into its proprietary funds. See Figure 3.

Figure 3. UBS Purchased $614 million of COFINA 2007 Series B Bonds for Its Funds

COFINA 2008 Series A

In 2008, UBS Financial Services of Puerto Rico was the sole underwriter of the $737 million Series B bonds sold only to Puerto Rican investors. None of the other 18 underwriters of the 2007 Series A or of the other 11 underwriters of the 2007 Series B COFINA bonds participated in the 2008 Series B COFINA bonds. See Figure 4.

UBS purchased 100% of the $737 million COFINA 2008 Series A bonds into its proprietary funds. See Figure 5.

Figure 5. UBS Purchased $735 million of COFINA 2008 Series A Bonds for Its Funds

As with the ERS bonds, UBS bought the COFINA bonds it underwrote in 2007 and 2008, making room for these bonds by selling other portfolio holdings. There was no other market for the COFINA 2008 Series A bonds or UBS used its control of its proprietary funds to maximize its fees from underwriting and selling the 2008 COFINA Series A bonds.

In today’s post we show that UBS underwrote unmarketable Employee Retirement System bonds and bought them into the UBS Funds in 2008. Friday, we’ll show similar conflicts led UBS to underwrite unmarketable 2008 COFINA bonds and then stuff them into the UBS Funds.

The Puerto Rican Employee Retirement System was acutely and chronically underfunded. Figure 1 is a plot of the PR funding ratio and the median of the 50 states’ funding ratios. The states median funding ratio fluctuated between 80% and 100% from 1990 to 2013 while the PR funding ratio was approximately 20% until 2008 after which it dropped even further. For context, the next three worst average funding ratios from 2007 to 2011 were Illinois at 51%, Connecticut at 58% and Kentucky at 59%.

Merrill Lynch attempted to sell $7 billion of ERS Pension Obligation Bonds in 2007 but failed.1 UBS replaced Merrill Lynch as advisor to the ERS and was the lead underwriter of the ERS $1,588,810,800 2008 Series A bonds. See Figure 2.

UBS was the lead underwriter on the 2008 Series A ERS bonds but there were 11 other underwriters including Merrill Lynch, Citi and Wachovia. We don’t currently have information on how much of the 2008 Series A ERS bonds UBS committed to sell but we do know that it purchased 41% of the issue into its proprietary bond funds. See Figure 3. We also know that UBS bought some 2008 Series A bonds into individual Puerto Rican customer accounts.

The excerpt from the first page of the 2008 Series A ERS Offering Circular in Figure 2 includes the following language.

The System currently contemplates offering additional parity Bonds (the “Series B Bonds”) in other jurisdictions. The Series B Bonds would be offered by means of one or more separate Official Statements and may not under any circumstances be purchased by residents of Puerto Rico.

Page 7 of the January 29, 2008 Series A Offering Circular expands on the commitment to not sell 2008 Series B bonds in Puerto Rico. See Figure 4. The language excerpted from the 2008 Series A Offering Circular in Figures 2 and 4 is unambiguous and was protection for Puerto Rican investors in the 2008 Series A bonds since the Series B bonds would be on par with the Series A bonds and would only be issued if the Series B bonds passed the market test.

Something dramatic happened between January 29, 2008 and May 28, 2008. Rather than only being available to non-Puerto Rican residents as promised four months earlier, the 2008 Series B ERS bonds would only be sold to Puerto Rican residents. See Figure 6.

Figure 6. Excerpt from page 7 of ERS 2008 Series B Offering Circular.

Not only was there no market outside of Puerto Rico for the 2008 Series B ERS bonds on the terms they were being offered, there was no market for the bonds on the island either. UBS bought 89% of the 2008 Series B ERS bonds into its proprietary funds. See Figure 7.

The most interesting non-public documents in the UBS Puerto Rico municipal bond Fund saga will likely be the internal emails and memos at UBS and the communications between UBS and the ERS as they realize that there was no market for the 2008 Series B ERS bonds and the 2008 Series A ERS promise that the Series B bonds will not be sold on the island had to be abandoned.

There was a third and final ERS bond series issued in 2008 – the Series C bonds. UBS was the lead underwriter of the $300 million offering in June 2008. See Figure 8.

As with the 2008 Series A and Series B ERS bonds, the 2008 Series C bonds could only be purchased by Puerto Rican residents. See Figure 9.

Figure 9. Excerpt from page 7 of ERS 2008 Series C Offering Circular.

We don’t currently have information on how much of the 2008 Series C ERS bonds UBS committed to sell but we do know that it purchased 38% of the issue into its proprietary bond funds. See Figure 10.

Figure 10. UBS Purchased 38% of ERS 2008C Bonds for Its Proprietary Funds
UBS’s trading in the ERS 2008 Series C bonds raise some additional questions. By January 2010 the UBS Funds held roughly $50 million of the Series C bonds maturing in 2043 and by September 2011 held $110 million. Unlike the Funds’ purchases of Series A and Series B bonds, the Funds’ $110 million purchases of this bond are not reflected in the EMMA data available here.

1 Near contemporaneous analysis of Merrill Lynch’s failed attempt to underwrite ERS bonds and the harm to ERS caused UBS’s subsequent involvement can be found in Conway MacKenzie, Inc., October 2010, Review of the Events and Decisions That Have Led to the Current Financial Crisis of the Employees Retirement System of the Government of Puerto Ricoavailable here.

1Análisis contemporáneo acerca del intento fallido de Merrill Lynch en suscribir bonos de la ASR y el daño causado por UBS a la ASR puede ser encontrado en el artículo de Conway MacKenzie, Inc. de octubre de 2010, Review of the Events and Decisions That Have Led to the Current Financial Crisis of the Employees Retirement System of the Government of Puerto Rico disponible aquí.

Tuesday, November 4, 2014

We’ve written extensively about the UBS Puerto Rican Municipal Bond Funds. You can find our earlier blog posts here. In a January 2014 blog post available here, we pointed out that the losses suffered by investors in the UBS PR Funds were caused by the portfolios’ high leverage and concentration in Employee Retirement System and Sales Tax Authority (COFINA) bonds. In a December 2013 post here we wrote of the conflicts of interest first identified by David Evans of Bloomberg (David Evans, UBS in Puerto Rico Pension Gets Fee Bonanza Seen as Conflicted, February 27, 2009, Bloomberg) which led UBS to stuff the Retirement System Bonds into UBS’s Funds.

In a series of blog posts this week and next week we’ll document UBS’s conversion of its Funds’ portfolios in 2008. As we’ll explain Wednesday, UBS underwrote unmarketable Employee Retirement System bonds and bought these conflicted bonds into the UBS Funds in 2008. On Friday, we’ll show the same conflicts led UBS to underwrite unmarketable 2008 COFINA bonds and then stuff them into the UBS Funds. Next week we’ll further develop the harm to investors UBS caused by stuffing the conflicted ERS and COFINA bonds into its Funds.

Figure 1 and Figure 2 illustrate how UBS dramatically changed the UBS Puerto Rico Funds in late 2007 and early 2008 using the Tax Free Puerto Rico Fund II and Puerto Rico Fixed Income Fund II as examples. UBS sold off $350 million other bonds and bought $530 million of ERS and COFINA bonds it underwrote in these two funds alone.

The Tax Free Puerto Rico Fund II held no COFINA bonds on June 30, 2007. UBS participated in COFINA underwritings on July 13, 2007 (COFINA Series 2007A Offering Circular available here) and on July 18, 2007 (COFINA Series 2007B Offering Circular available here). We don’t currently have the 3rd Quarter 2007 Quarterly Review but the November 30, 2007 Annual Report shows the Tax Free Puerto Rico Fund II Fund then owned $93.4 million of COFINA bonds. UBS was the sole underwriter of the (COFINA Series 2008A Offering Circular available here.)

The Tax Free Puerto Rico Fund II held no ERS bonds on November 30, 2007. UBS participated in underwriting three series of ERS bonds in 2008. The Series 2008A Offering Circular is available here, the Series 2008B Offering Circular is available here and the Series 2008C Offering Circular is available here.

Between June 30, 2007 and November 30, 2008 UBS caused the Tax Free Puerto Rico Fund II to pay $188,943,300 for the ERS and COFINA bonds and these two issuers’ bonds went from 0% of the Tax Free Puerto Rico Fund II portfolio to 50% of the gross assets and 98% of the net assets of the Fund. UBS sold roughly $190 million of other issuers’ bonds out of the Tax Free Puerto Rico Fund II to make room for the ERS and COFINA bonds it was underwriting.

Figure 2 presents holdings by issuer for the Puerto Rico Fixed Income Fund II on June 30, 2007 (from Quarterly Review available here), November 30, 2007 (from the Annual Report available here) and on November 30, 2008 (from the Annual Report available here).

The Puerto Rico Fixed Income Fund II held no COFINA or ERS bonds on June 30, 2007. Between June 30, 2007 and November 30, 2008 UBS caused the Puerto Rico Fixed Income Fund II to pay $340,357,374 for the ERS and COFINA bonds and these two issuers’ bonds the ERS and COFINA bonds went from 0% of the Puerto Rico Fixed Income Fund II portfolio to 44% of the gross assets and 88% of the net assets of the Fund. UBS sold roughly $335 million of other issuers’ bonds out of the Puerto Rico Fixed Income Fund II to make room for the ERS and COFINA bonds it was underwriting.

The Securities and Exchange Commission announced sanctions today against 13 brokerage firms for selling high risk Puerto Rican municipal bonds in March 2014 in denominations well below the $100,000 minimum specified in the offering circular. The SEC press release with links to the individual orders can be found here.

The Puerto Rico offering document (available here) says the bonds can only be traded in denominations greater than $100,000. The Bond Buyer story pointed out that 70 customer trades in the first few days of trading (by 4:57 pm on March 18, 2014) were below this minimum denomination intended to protect investors.

Don’t look for these trades in the EMMA data. As we wrote about in The MSRB Re-Writes History, the MSRB edited the tape to delete or modify these trades even though they had already settled.

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